Video game industry poised for a shootout

(IDG) -- Microsoft doesn't settle for second place. The office desktop? Redmond owns it. Internet browser? Bill Gates and company won that years ago. A new generation of Web services? Already miles ahead. Now Microsoft is ready to jump into a new arena: your living room.

Later this month, the tech titan will finally unveil the Xbox, its high-profile entry into the video game business. Venturing far from its home turf -- operating systems and business software -- Microsoft is taking dead aim at a multibillion-dollar market now dominated by a pair of well-entrenched giants, Sony and Nintendo. It's shaping up to be a costly three-way hardware war that's destined to speed the convergence of entertainment and computing, expand the ranks of game players beyond 14-year-old boys and extend Microsoft's reach deep into the consumer market.

At the outset, the mission is to capture the imagination of gamers. But the real payoff is several years away, when the game console turns into an all-purpose entertainment device, complete with CD and DVD players, Web browsing and interactive TV. And the contest, which Sony kicked off last October with the U.S. debut of its PlayStation 2 console, is about to get a lot more exciting.

The next round will play out at the annual E3 electronic entertainment trade show in Los Angeles. On May 16, the day before the show opens, Microsoft will reveal the Xbox's launch date and price. (The rumored debut is early October; pricing should be in line with PlayStation2's $299.) Within hours of Microsoft's event, Nintendo will hold a splashy shindig to hype a new console of its own, the GameCube. E3 will also be abuzz with anticipation of Nintendo's Game Boy Advance, which makes its U.S. debut June 11. And the air of anticipation will only build as developers introduce a slew of new games for PlayStation 2.

It all adds up to a renaissance for the video game industry -- one you can expect to hear a lot more about. Microsoft, for instance, has pledged to spend $500 million advertising and marketing the Xbox in the 18 months following its launch -- the largest product push in the company's history. "We intend to make a seismic impact with the launch," says David Hufford, Xbox's marketing manager.

The big bet makes sense. Microsoft has long dabbled in consumer markets; it provides Internet content via MSN sites like MoneyCentral and Carpoint, for example, and ranks among the top 10 providers of PC games with titles like Flight Simulator and Age of Empires. But with Xbox, Redmond sees a chance to dramatically increase its consumer business. "For our first 25 years, Microsoft focused on business applications," notes Hufford. "In the next 25, we're going to be touching the consumer more."

A cola war for the '00s?

That doesn't sit too well with Sony. Though the company lost money on games in its fiscal year ended March 2001 due to costs associated with the PlayStation 2 launch, in fiscal 2000 games accounted for a third of Sony's operating profits. This year the company is counting on a rebound, so it's not about to give up control of the TV to Microsoft. "We're very proud and protective of the market share we've established," says Jack Tretton, senior VP for Sony Computer Entertainment of America. He adds that after a slow start -- Sony was unable to satisfy demand at Christmas -- the company has already shipped 3 million PlayStation 2 units in the United States and 10 million worldwide, on top of 80 million first-generation PlayStations. Total number of Xbox users? Zero. Microsoft has some catching up to do.

In addition, Tretton says Sony "won't be dwarfed in marketing spending." So figure on another half-billion for a PlayStation 2 ad blitz.

Then there's Nintendo, which will spend $75 million on the Game Boy Advance launch this year, according to Nintendo of America spokeswoman Beth Llewelyn, who won't give details on Gamecube plans. She does say that the company's ad spending worldwide on its two systems over the next 18 months should be close to what Microsoft has budgeted.

Powering up the software industry

All of this has software firms drooling. "We're just licking our chops here as third-party publishers," says Brian Farrell, CEO of THQ, publisher of the WWF Smackdown wrestling games. "Think of the consumer awareness. This is going to be a war for hearts and minds, for living rooms and kids' bedrooms everywhere."

The industry could use a boost. Sales have been soft for a year: Sony has been increasing PlayStation production slowly, Sega is exiting the console business and the Nintendo 64 platform is aging. U.S. video game title revenues in 2000 were roughly the same as in 1999, at about $6 billion -- and 2001 won't be much better, though unit sales continue to grow.

But the industry isn't worried. It expects big things in 2002 and beyond. The conventional wisdom is that each console generation produces 50 percent more revenue than the one before. If that holds true this time, it won't be long before the gaming industry tops the $7.7 billion that Hollywood raked in last year at the box office -- a big market indeed.

Consider some back-of-the-envelope math. THQ's Farrell thinks the combined hardware sales of all three new game consoles can reach 200 million units by 2005. Assume he's right, and then estimate that the average user buys 10 games -- a safe guess, given that the typical first-generation PlayStation owner bought 17 games. That gives you a Ray Kroc-like 2 billion software units sold. Figure an average retail price of $30, and you get a potential market of $60 billion. Throw in the PC and handheld market, says Edward Williams, an analyst with Gerard Klauer Mattison in New York, "and you could get a $100 billion market opportunity over five years." And that's just for software.

For now, Nintendo appears to have the most secure position of the three hardware players. Both Sony and Microsoft are ceding Nintendo a big slice of the market: the youngest game players. Nintendo owns key software franchises like Pokemon, Mario Bros. and the Legend of Zelda, none of which will appear on the other systems.

For Nintendo, the challenge is to attract an older audience. The company's new Game Boy is geared to do just that, according to Williams. "Game Boy Advance is bigger, faster, better," he says. "The screen is 50 percent larger, and the processor is twice as fast as the Game Boy Color."

So Sony and Microsoft will fight it out for older players. In that battle, PlayStation holds an early edge, if for no other reason than it has many more titles and a loyal group of gamers.

The Xbox might have fewer games -- at least at first -- but it will be the more technologically impressive. The Xbox includes a 10GB hard drive. (The PlayStation lacks one.) It boasts a graphics processor far speedier than the one in the PlayStation. Then it has a 733-MHz Intel processor and a Windows-based operating system -- a plus for developers used to creating PC games (see "Microsoft plays nice, and it pays off," link below). It has built-in broadband connectivity -- something not found on the PlayStation. Both boxes have a DVD player.

The broadband connection suggests the box could be used for online gaming, for downloading new game levels, weapons and characters, or even for entirely new games. Microsoft's Hufford says online gaming won't be a reality until 2002, though he does mention that Microsoft thinks the Internet will play "a major role in the future of video gaming."

Consumers seem ready to pounce on the new hardware. On Yahoo Clubs, for instance, more than 60 sites are devoted to Xbox arcana and nearly as many for the Gamecube. PlayStation has attracted more clubs than the other two combined.

Investors are excited, too -- but not by the hardware makers' stocks. Xbox, after all, won't contribute to Microsoft's bottom line for quite a while. Hufford notes that videogaming is a razor and razor-blade business; Redmond will make its money back later. (In a report earlier this year, Merrill Lynch analyst Henry Blodget estimated that Microsoft would lose $2 billion on the Xbox before turning profitable in 2005.)

Wall Street has plenty of ways to wager on the video game wars. Shares of the leading game publishers have been soaring at a time when most tech stocks have been pounded. Since the end of 2000, for instance, shares of Electronic Arts, the industry leader, have gained 34 percent. Its rivals have done even better: THQ is up 52 percent; Activision has gained 73 percent. Electronics Boutique, a West Chester, Pa.-based retailer focused on video gaming, is up 46 percent. And Nvidia, maker of the graphics chips in the Xbox, has soared 144 percent.

The sector offers advantages over other tech stocks, says Michael P. Wallace, an analyst with UBS Warburg. "They have a lot of earnings visibility," he notes. "Plus, the industry is largely recession-proof. In the 1990-91 recession, the video game sector didn't miss a beat."

While the battle will be fierce, the consensus view is that there is room for all three hardware makers. (A skeptic might point out that Sega, which had been the third player in the field, recently opted to exit the hardware business.) Robert Kottick, CEO of Activision, known for extreme sports games like the Tony Hawk skateboarder line, says there's "never been a better time" to be selling video game software.

The key for a three-way success will be to attract a new breed of gamer. Microsoft insists that the new technology will make that happen. "You can really suspend people's disbelief," says Hufford. "The production values are movie-like. People will wonder if you're watching a Nascar race, or playing a Nascar game. They'll wonder if you are playing the game Shrek, or watching the movie Shrek. And people will get hooked."